PLW - Consumer Inflation Trends Lower

2023-06-13 15:30:00 ET

Summary

• Inflation continues to fall, with CPI dropping from 4.96% to 4.13% on a YOY basis, increasing the probability of a Fed pause from 77% to 94%.
• The real rate of interest has turned positive, and the Fed is expected to pause and perhaps raise rates one more time.
• The market is discounting a 63% chance of a 25bps hike at the July 26th meeting and the Fed’s end goal may be to sail just underneath a real rate of around 2.5%, which has equated to recession in the past.

By Douglas R. Terry, CFA

Inflation continues to fall. On a YOY basis, CPI dropped from 4.96% to 4.13%. With this print, the probability of a Fed pause went from 77% to 94%. Falling inflation rates are a result of ((A)) more restrictive money or ((B)) falling demand. This is not a binary question, and there is a causal relationship. 11 months ago, we hit the highest rate of inflation as measured by CPI since 1981. This was the result of a 3-year period of the easiest money in the history of the data set (about 70 years). As of today, the real rate of interest, calculated as Fed Funds less CPI, has officially turned positive. Where will real rates go from here? The Fed is expected to pause and perhaps raise rates one more time. They have been very transparent in telegraphing policy, so this is credible, and the market is discounting a 63% chance of a 25bps hike at the July 26th meeting. In the past, a real rate of around 2.5% has been a level that has equated to recession. Is this the Fed's end goal? Are they shooting to sail just underneath this level?

Now you need to consider the likely level of inflation moving forward. Inflation is 4.1% and falling. How sticky will it be? 1-Year expected inflation is 2.65%. A Fed Funds Rate of 5% with inflation falling toward 2.5% puts us right at that 2.5% real rate number. I bet Powell wishes it were so easy.

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